Value Buys Among the Dow 30

With the high-flying Dow Jones industrial average hitting the 14,000 mark for the first time ever, plenty of investors are turning jittery, worried that piercing the market's psychological barrier signals danger ahead. That's because some market analysts argue the Dow is peaking and will be heading south.

Not so fast. The Dow's sprint isn't over. One big reason: Of the index's 30 components, at least nine are trading way below their fair market, or intrinsic, value, according to some valuation studies.

"Some of the components, such as Wal-Mart (WMT), Procter & Gamble (PG), and Johnson & Johnson (JNJ), remain very undervalued, based on our discounted cash-flow model analysis," says Pat Dorsey, director of research at Morningstar (MORN), an independent research firm. Another reason to buy them, he adds, is that large-cap stocks have just started to come back, after six years of lagging behind small caps. During all those years, the smaller stocks sizzled and handily outscored blue chips and other stocks with large market values.

Playing Defense

Johnson & Johnson, for example, hasn't been this cheap in 15 years, says Dorsey. The stock, trading at $61 a share, is worth $80, he figures. J&J is trading at just 15 times the Standard & Poor's estimate of its 2007 earnings—way below its peers in the pharmaceutical, medical device, and consumer products industries.

Wal-Mart, the world's largest discount retailer, is itself selling at a big discount at $48 a share. The stock is worth at least $60, according to Morningstar's calculations. Its a p-e of only 15 is below that of its peers. Consumer products giant Procter & Gamble, which trades at $61, is worth $77 a share, figures Dorsey.

Loran Braverman of Standard & Poor's, who rates Procter & Gamble a "strong buy," figures the stock deserves a premium to its peers because of its earnings record and its leading positions in its various markets. It is trading at 20 times S&P's estimate of fiscal 2008 earnings. Braverman has a 12-month target of $77 a share. The level of risks in P&G and the other two stocks, he says, are "below average."

The Dow's components and many other blue chips have a long way to go on the upside, says Dorsey, not only because of their earnings growth but also because they are a "defensive" play in this fast-climbing market. He says that with all the negatives around, including the subprime mortgage market fiasco and the inflationary pressures the Federal Reserve keeps warning about, a fair chance exists that the market could tumble soon. The large-cap stocks, Dorsey says, can serve as a protection against such an eventuality because they will, in all likelihood, be able to absorb any downward market shock well: They are not exactly coming off high levels, having been laggards in the past several years. He maintains that the small caps are likely to suffer more during the next downturn.

Enjoy the Ride

The other Dow components that analysts figure are buys are JPMorgan Chase (JPM), American Express (AXP), American International Group (AIG), Home Depot (HD), 3M (MMM), and Citigroup (C). Georges Yared, founder and chief investment officer of Yared Investment Research, says Citigroup's strength lies in its product and geographic diversity and continued earnings quality improvement. He estimates the stock, trading at $50, is worth $65 a share, with a dividend yield of 4.12%.

According to Morningstar's projections, JPMorgan Chase, trading at $48, is worth $63; American Express, now at $60, is worth $70; and 3M, now trading at $86 a share, is worth $103. According to Standard & Poor's, Home Depot and American International Group are also undervalued. S&P's Michael Souers, who follows Home Depot, says the company's growth prospects in the international markets are focused on China, Canada, and Mexico, and that its strong balance sheet, financial flexibility, and abundant free cash flow add to its allure. Cathy Seifert, who tracks AIG at S&P, figures that on a sum of-the-parts valuation, AIG is worth $85 a share, or about 13.4 times her 2007 earnings estimate of $6.35 a share. The stock is trading at $70.

Dorsey doesn't worry about the Dow topping out soon. Dorsey says that unless the index swings up in a mad rush and hits 16,000, investors should just enjoy the ride. The thing to keep an eye on during the upward trek: the individual Dow components' valuations. They are apt to bounce up as the market's momentum continues, allowing more leeway for further advances in their intrinsic values. But should they become stagnant at some point, that would be the time to worry and possibly take profits or bail out. The best advice at this point: Keep your eye on the ball—and the individual valuations of the Dow components.